With no set end date for the trade, margin buying is undated.
1. Short selling stocks
Short selling is selling stock that you don’t own, in the hope that it will fall in price and you can buy it b ack cheaper.
Short selling is not universally admired. Many people believe it is immoral to bet on a company’s share price going down. Over 200
years ago, Napoleon Bonaparte claimed that short selling was unpatriotic, and numerous politicians have subsequently agreed with him. Historically, short selling has frequently been banned or heavily regulated. During the 2007–2008 financial crisis, it was illegal to short the shares of banks and other firms in the financial industry. This seriously affected the hedge fund I was working for at the time, since we had to keep checking if a given trade wa s permitted.
Nevertheless, most economists believe that short selling allows the market to become more efficient. Without it share prices would climb too high, resulting in more spectacu lar crashes.
Short selling, and buying stock on margin, are two sides of the same coin: both use leverage to make bets on the price of the same under lying asset.
As they use leverage, buying on margin and short selling both require the use of a margin account ; in this book I’ll use the term margin trading to cover both types of trading.
Two things that make short s elling weird The slightly weird thing about short selling is the concept of borrowing stock and having to pay a fee for the privilege. But this is no different from buying on margin, where we ‘rent’ money
and pay a fee – the interest payment. When selling short you are renting stock for a bo rrowing fee.
The even weirder thing about short selling is that you have to reimburse dividend payments . To understand why, here is a simple example. Suppose Mr A is the original owner of the stock. Miss B
wants to sell the stock short, so she borrows it from Mr A. Miss B then sells the sto ck to Mrs C.
When a dividend is paid it will go to the current owner of the stock, Mrs C. However, Mr A is also expecting to get his dividend payment: the loan contract doesn’t affect his rights to a dividend (in fact Mr A may not even realize his stock has been lent out by his broker). So, Miss B has to pay Mr A the dividend they would otherwise have earned.
Here is a tangible example of a short sale. We want to bet on Citigroup stock falling in price, and we want to short up to $6,000 in stock. With a maximum leverage factor of 2 we must have at least $3,000 in our trading account. The stock borrowing cost is 4.8% per year, and no dividends are expected to arrive during the next month.
Example: short stock sale
Short selling is a physical trade where we borrow the under lying asset.
Stocks are listed o n exchanges.
With no set end date for the trade, short selling is undated.
1. Exchange traded funds (ETFs)
Exchange traded funds (ETFs) are a special type of share which allows you to get exposure to indices, such as the S&P 500. ETFs are also available that track many other kinds of assets, such as bond indices and commodities. You can buy them with leverage, or sell them short. This opens up trading in many different kinds of assets to owners of margin trading accounts. This is a real boon for US traders, who are not currently permitted to use certain other kinds of levera ged product.
There are also ETFs that come with their own leverage included.
These are potentially very dangerous. You cannot control the amount of leverage they use, and they have very high fees. Avoid the se products.
Margin trading of ETFs has the same characteristics as margin trading of stocks: they are physical products, which are exchange traded , and undated .
1. Foreign Exchange (FX)
FX, forex, foreign exchange; whatever you call it, is one of the most popular products for leveraged trading. Trading FX is just betting on the exchange rate of one currency agai nst another.
Almost anyone who has been on vacation to another country understands foreign exchange. If I want to visit New York, I’ll exchange some of my British pounds for US dollars. Right now, I can buy $1,000 for £750 (an exchange rate of £1 to $1.3333). In the jargon, betting that the pound will get weaker relative to the dollar means I have ‘gone short’ pounds versus dollars’ or 20
sold GBPUSD. ¹77 Alternatively, if I thought the pound would 20
strengthen, I could have gone long or bought GBPUSD. ¹78 As yet this is not a leveraged trade, because I haven’t borrowe d any money.
Suppose the exchange rate moves in my favour and falls to $1.25
per £1. My $1,000, which I bought for £750, is now worth $1,000 ÷
1.25 = £800. I have made a £50 profit.
FX trading in real life works in exactly the same way, with two important exceptions. The bad news is that nobody gets to visit the Big Apple. The good news is that we don’t need to come up with £375. The FX broker will lend us most of it.
As with margin trading, the amount a broker will lend depends on their maximum leverage ratio . Many FX brokers offer a ratio of 20
30:1 or higher. ¹79 But let’s use a more modest leverage limit of 9:1. That means with a £75 deposit we can borrow 9 times that amount, £675. That gives us a total of £750 to trade with.
My broker currently charges an interest rate to borrow British pounds which is equal to GBP LIBOR (currently 0.3%) plus a funding spread of 1.5%, for a total of 1.8% per year. The broker will also pay interest on any dollars I deposit with them. This is equal to the reference rate, 1.7% for USD LIBOR, minus a funding spread of 1.5%, equal to 0.2% a year.
The traded spread is 1.3334 – 1.3332 = 0.0002. FX spreads are often expressed in pips . A pip is 1 ÷ 10,000 or 0.0001. The spread here is 2 pips wide.
Here is an example of an FX trade:
Example: winning FX trade
Notice the effect of leverage: the currency moved by around 6%
(from 1.3332 to 1.2501) but we made around ten times that
(65.3%). Of course, if the FX rate had gone the other way, we’d have lost money.
FX trading is a physical trade where we use leverage to borr ow currency.
FX trading is done over the counter (OTC), not via an exchange.
With no set end date, FX trading is undated.
1. Contracts for difference (CFDs)
At this point you might think that leveraged financial trading is very complicated. You have to borrow something (money, shares or foreign currency), pay various kinds of fees, and keep track of interest and possibly divide nd payments.
But what if someone was prepared to do all that w ork for you?
Then you could just say “I want to bet on the pound going down against the dollar (short GBPUSD)” or “I want to bet on Citigroup shares going down in price (short Citigroup)”, and they would take care of the fi ner details.
That someone is your friendly neighborhood CFD broker. CFD stands for contract for difference. You enter into a contract with your broker where they will pay you the difference: the movement of the relevant price during the life of the contract. A CFD is a derivative product, as we don’t ever own the under lying asset.
Let’s implement a short GBPUSD trade using CFDs. We’ll first consider an undated CFD trade with no set expiry date, and then look at dated CFDs later in the chapter. Unlike the trades we’ve seen so far, CFDs are offered only in standard units. A single contract with my broker for GBPUSD is for £10,000 worth of currency. My broker has a minimum margin requirement of 3.33%, equating to a leverage factor of 30. As I will discuss later in the book, this is too high. To use a more sensible leverage factor of 10 we’d need to dep osit £1,000.
You can also use CFDs to bet on share prices. Going long in a particular share through a CFD is similar to buying stock on margin. When you buy shares through a CFD you normally receive the same dividend as if you’d bought the shares on margin, although many brokers only pay 80% or 90% of the dividend, keeping the difference for a little e xtra prof
it.
Similarly, betting on share prices falling with a CFD is just like selling short. When you go short a stock via a CFD you will be charged 100% of the value of any dividend payments t hat are due.
Di vidend dates
There are three important div idend dates: The date when the size of the dividend payment i s announced.
The ex-dividend date. If you buy the stock on or after this date you won’t be entitled to t he dividend.
The payment date: when the dividend is ac tually paid.
Suppose a stock is trading at $100 the day before the ex-dividend date and is due to pay a $10 dividend. All other things being equal, the stock will drop $10 in price when the market opens on the ex-dividend date, as anyone buying the stock that day will not receive the relevant dividend. To smooth out this price drop, CFD providers normally credit holders of long positions with the dividend on the ex-dividend date, rather than waiting until the payment date. If you are short, they will debit your account on the ex-di vidend date.
As with all leveraged trading, CFDs are subject to margin calls if the market moves against your position, and auto-liquidation if things go really wrong. Finally, an important feature of CFDs is that they can be used to trade many different kinds of financial products, not just FX or shares, including ETFs, commodities and crypt ocurrencies.
At the time of writing it is difficult for most non-professional traders in the US and certain other countries to access CFDs. You should check the local regulatory situation befor e you trade.
CFDs are derivatives.
They trade over the co unter (OTC).
With no set end date, they are undated. Some special types of CFDs are dated, and I will discuss these later.
1. Spread bets
I have casually used the term ‘bet’ quite a few times because, in my opinion, trading and gambling are essentially identical activities on which only the underlying asset i s different.
Trading and gambling
Surely gambling is the refuge of sad addicted losers, whilst trading is a respectable profession? This is a massive oversim plification.
There are a whole series of activities which involve taking risk: betting on horses or football games, trading, and investing (the boundary between trading and investing is also a matter of some debate). Even putting your money in the bank, or under your bed, is a risk-taking activity: you risk the bank going bust, or inflation depreciating the value of your wealth.
In fact, it’s irrelevant what the risk-taking activity is, but how you do the activity signifies whether you are a loser or a respectable risk taker.
Sad, addicted losers take dangerously large risks in situations where the odds are against them: betting on long-shot horses, sticking dimes or 50p pieces into slot machines, investing in dodgy unregulated products, trading binary options, or day trading (and I explain why that is dangerous later i n the book).
Smart gamblers take modest risks when the odds are favorable: betting on horses where they have a proven edge, card counting in casinos, long-term investing in diversified portfolios, or trading wi th a system.
However, there is a big legal difference between trading a nd gambling.
Spread betting in the US is currently illegal. US readers should hastily skip to the next section, lest they be tempted to br eak the law.
In the UK gambling profits are tax free (the government gets its cut by taxing bookmaker profits). But taxes on share trading are potentially taxable. This creates a gaping loophole. If you try and predict share prices by buying shares (possibly on margin) or going long a CFD, you have to pay tax on any profits. But if you place a spread bet on the share price then your profits are 20
usuall y tax free. ²70
Tax
Most traders have to worry about tax, unless they are living in an exotic offshore location. It is impossible for me to cover this subject comprehensively here as tax rules are complex, always changing, and different for each country. This is a very brief overview of how taxes affect most traders, but you will need to find out what the local rules are and you should consult a professional tax advisor.
It’s unusual for individual traders to have to worry about income tax , since it will be unlikely that their trading will be
classified as a proper business. Tax authorities are reluctant to allow this, since you would be able to offset your trading losses against other income and reclaim the tax on the costs of running your trading business (such as data feeds).
The main tax that affects traders is capital gains tax .
Essentially, if you buy something cheaply and sell it for a higher price, then you have to hand over some of your profits to the government. In the UK, spread bets are free from capital gains tax, but otherwise this tax is ha rd to avoid.
Dividend income from physical positions in shares and ETFs are also subject to tax. Traders who own derivatives do not receive dividends, but the treatment of carry and financing costs for spot FX and undated derivatives is very complicated, and you will definitely need to check this with a p rofessional.
In certain countries you have to pay a transaction tax when you buy shares. This is known as stamp duty in the UK and is currently 0.5% of the trade value. You can avoid paying stamp duty by using derivatives like CFDs or spread bets. Usually ETFs are also free from stamp duty.
You can also avoid tax by trading inside a tax-free wrapper: 401K
and Roth IRAs in the US, ISAs and SIPPs in the UK. Unfortunately, not all products are available inside these wrappers. Finally, it is possible to adjust your trading strategy to reduce the tax that is payable. This is a complex area that I will not cover i n this book.
Betting on share prices in this way is known as spread betting .
The name comes from the trading spread quoted by brokers. Like CFDs, spread bets are a derivative product where we don’t actually own the underlying asset. We’ll first consider undated spread bets, and then look at dated spread bets later in the chapter.
A spread bet works in a very similar way to a CFD, if we ignore the different tax and regulatory treatment. With a spread bet we bet a certain amount ‘per point’. A point is a given movement in the price. For GBPUSD a point is usually equal to a pip , a 0.0001 move in the currency. For simplicity the price is often quoted in points. The GBPUSD rate would be quoted at 13333 rather than 1.3333.
The minimum bet per point with my broker is £1 per point. A single point of GBPUSD at a price of 13,333 has a notional value of 13,333 × £1 = £13,333 worth of currency. To keep our leverage factor ²¹ at 10 we’d need to deposi t £1,333.30.
As with spot CFDs, because there is no fixed expiry date, we have to pay a daily financing charge. For this reason, these undated spread bets are often called daily funded bets .
Here’s how it work s in detail:
We can also spread bet on share prices. As with CFDs, if you place a long spread bet on shares then you receive a dividend credit to your account on the ex-dividend date. Your account will be debited if you have a short position on shares. Also, just like CFDs, spread bets can be placed on a variety of financial instruments as well as FX and stocks.
Naturally, spread bets are subject to margin calls, and auto-liquidation.
Spread bets are derivatives.
They trade over the co unter (OTC).
With no set end date, they are undated. Some special types of spread bets are dated, and I will discuss these later.
1. Futures
The final leveraged financial product we consider are futures .
These are a bet on where the price will be at a specific future date . So, futures are a dated produc t, and also a derivative , since we don’t actually own the underlying asset. Unlike the other derivatives we have seen so far (spread bets and CFDs) they trade on exchanges. The terms of the trading contract are standardized and set by th e exchanges.
The specific date of a future is known as the expiry , or settlement , date. There are normally a variety of
settlement dates on which we can bet. The dates that are available depend on the underlying asset you are trading. A future that expires on a specific date is known as a contract .
For FX, the relevant futures have contracts which expire every month. ²² Other futures, such as the US S&P 500 equity index, have quarterly contracts: every three months there is a new futures contract you can bet on. You can bet on what the price of the S&P 500 will be in March, June, September and December. Most futures have quarterly or monthly expiries, but there are some oddities. The gold future on the Chicago Mercantile Exchange has expiries every two months: in February, April, June , and so on.
Some futures, like crude oil, have actively traded expiries stretching years into the future. Others, like the future on the S&P 500, only have active trading in the nearest contract (the next contract to expire). We can hold a futures position to expiry, close it earlier, or roll it to the next futures contract. However, every time you roll you will have to pay
transaction costs on the roll trade (trading spread, and commission), and possibly capita l gains tax.
There is no explicit financing cost for futures, and if you buy a future based on an equity, you wouldn’t actually receive any dividends (nor will you have to reimburse dividends if you sold).
The price of futures already reflects the financing cost, plus any dividends if relevant. If the underlying price doesn’t change then the movement in the futures price will reflect the positive or negative carry that would be due in the under lying asset.
As an example, consider the GBPUSD spot FX trade example from earlier in the chapter. The interest rate to borrow GBP was 0.3%, and the rate you could earn on USD was 1.7%. In the original example the broker added and deducted financing spreads from these rates, but these will not apply to futures. The positive carry from shorting GBPUSD is equal to 1.7% – 0.3% = 1.4%. With a current FX rate of 1.3333 the futures price for GBPUSD in one year’s time must be: 1.3333 × (1–0.0 14) = 1.3522
Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Page 4
